Why this is a much more interesting period for income investors (and how to take advantage)

Strap in, everybody; things are going to get bumpy. That’s the view from Adam Kibble, Portfolio Manager for the Schroder Absolute Return Income (Managed Fund), where the team’s core view is that inflation over the next decade will be higher than central bank targets, and with higher inflation will come greater macro volatility, more “boom and bust”.

Whilst that sounds ominous, Kibble is interested in calling it as he sees it and preparing accordingly for the challenges and opportunities that will eventuate. In the following, as part of Livewire’s 2024 Income Series, Kibble unpacks these big calls and how to navigate the turbulence.

The bumpy part

Kibble points to several structural forces that will keep inflation higher than pre-COVID, namely the reversal of globalisation, more expensive energy and labour, and changing demographics. He adds that “fiscal austerity is out and fiscal dominance is in”, with governments needing to spend more money to fund social programs, decarbonise the grid, and build out defences and energy security. 

"More government spending is inflationary and makes the role of central bankers inflation targeting far more difficult”, says Kibble

A history lesson

Kibble described the period between the GFC and COVID as “not normal”, where growth was low, central banks were focused on generating inflation with negative rates and quantitative easing – “this was very unusual and it suppressed both economic and market volatility”.

Whilst the period was great for owners of capital, “as asset prices gained significantly as valuations went extremely expensive”, the vast majority of wage earners didn’t benefit, according to Kibble.

“This has increased inequality, and with it social discord and will likely lead to more populist governments and fiscal spending. As a result of government policies during COVID and central banks being slow to react, we now have an inflation problem”.

The silver lining

Whilst the world is in a different investment environment post COVID, with higher market volatility and greater dispersion between asset classes and within asset classes, this environment creates opportunity according to Kibble.

“Central banks are actively managing interest rates to control inflation, something we haven’t seen since the mid-2000s. As mentioned above, bond-equity correlations have shifted and are definitely less reliably negative”.

“For an active manager with flexibility and breadth (we have a global capability and can invest across the broad spectrum of fixed income assets), this is a much more interesting period, compared to pre-COVID”, says Kibble.

"More volatility and more dispersion equals more opportunity to add value and deliver on investment objectives", says Kibble.

What it means going forward

With the reversal of globalisation and greater geopolitical fractions, inflation looks like it will be structurally higher going forward, notes Kibble, adding that “the biggest issue with higher inflation for investors is the bond-equity correlation flips and is unstable".

“For the past 30 years, investors have benefited from a negative correlation between bond returns and equity returns; with higher inflation this correlation has flipped to positive. When bonds are doing badly, equities are doing badly”.

In such an environment, Kibble suggests that investors have to be much more dynamic between their bond and equity allocations and “in periods when inflation is rising, this means higher allocation to cash, or cutting duration risk (interest rate exposure), as adding bonds is actually adding risk, not diversifying risk”.

How is Schroders seeing it?

In assessing the possible outcomes from here, Kibble notes that the base case remains the "hallowed soft landing," whereby central banks have tightened policy to curb inflation and succeed without breaking the economy and triggering a recession. Such a situation would be "good for both bonds and equities." 

The bear case is twofold, according to Kibble. 

"Either central banks hold rates too high for too long and something breaks, resulting in a recession, which would be bad for equities and better for bonds (although credit will lag), or inflation doesn’t fall and has already bottomed leading to more rate increases, which would be bad for both equities and bonds". 

So, how is Schroders seeing it? 

"Right now we are in the soft landing camp as the most likely scenario, but as information changes so will our view", says Kibble. 

How is Schroders Investing?

For Kibble, stickier inflation has meant the Schroder Absolute Return Income Fund has had structurally less duration (interest rate exposure) and leant more on credit exposures to generate excess returns over the past year.

“We have had the view that higher inflation would prevent the Reserve Bank from cutting rates this year, despite a very weak economy”.

That view had seen Schroders managing the duration exposure based on valuations – “When no cuts to official rates are priced into market yields we have extended duration exposure, as was the case in the fourth quarter of 2023, capturing capital gains as bond yields fell”.

Conversely, in periods when multiple rate cuts have been priced, as at the end of the first quarter of 2024, the team have cut duration exposure to insulate the portfolio from capital loss.

“More recently, following the latest inflation data, we have extended duration again as yields increased and the first official rate cuts were pushed out to late 2025”, adds Kibble.

When it comes to credit exposures, Kibble shares that the team have “focused on valuations and sought out the cheapest sectors or regions that offer the most attractive spreads for the additional risk”.

“As global investment grade and high yield sectors performed well over the first quarter of this year, credit spreads (the additional return for taking on credit risk) have contracted to very expensive levels”, says Kibble, adding that “We have mostly exited this sector, favouring Australian investment grade corporates and global securitised assets where spreads are far more attractive for the risk”.

As an example, Kibble cites US BB corporate bonds yielding 2% over US government bonds, compared with Australian government bonds for Australian major bank subordinated debt with an A- credit rating, which is delivering 1.75%.

“Giving up only 0.25% extra return and moving from a BB-rated asset to a single A asset is a much better return for the additional risk”, adds Kibble.   

What is one risk markets are not talking about enough?

Whilst Kibble has some strong views and a clear game plan, he believes that difficulty remains in assessing if the premium being paid to investors is adequate enough for the risks being taken. 

"This is why valuing the risk premium is an important part of our investment process", adds Kibble.  

Kibble points out that risk typically multiplies as leverage increases, and it is not linear, "So we want to avoid the areas of the market with the most leverage as higher for longer interest rates will take their toll". 

Kibble believes that "Cracks are starting to appear", adding that the market has just seen the first AAA-rated US Commercial Mortgage Banked security take a loss of 30% of the original capital, with lower rated tranches (first to take losses) wiped out with a 100% loss. 

"The biggest leverage is probably in developed market sovereign bonds and with demands on government spending outpacing revenues and while fiscal discipline is anathema to populist leaders, government debt to GDP will continue to increase – this should result in higher risk premium for longer-dated government bonds".    

Looking ahead

The key to portfolio construction for Kibble and the Schroder Absolute Return Income Fund is “assessing the returns available for the risk taken across different fixed income asset classes”, says Kibble.

With capital preservation a key objective, alongside the return objective of cash plus 2.5%, “this drives the overall level of credit risk in the fund and the allocations across different fixed income sectors and regions”.

“Our process is based on three components - Valuations, Economic Cycle and Liquidity - as the three most important drivers for fixed income returns. Our cyclical time frame is typically 12 months ahead”.

Looking further ahead, Kibble refers back to the changing structural drivers mentioned at the top, resulting in higher levels of inflation and more volatile inflation.

“This will mean higher levels of nominal interest rates, resulting in higher income levels, increasing the attractiveness of fixed income as an asset class”.

“However, investors will need to be more dynamic in managing interest rate risk, as during periods of cyclical upswings, inflation will likely increase, central banks will hike rates, and the diversification benefits of fixed income will disappear”.

In practice, this will result in structurally lower levels of interest rate exposure through the economic cycle, for the Schroder Absolute Return Income fund, “but we will be more active in managing that exposure and more fully using the broad duration range that our mandate allows”.

Steady income on investments

The Schroder Absolute Return Income (Managed Fund) (CBOE: PAYS) offers investors the potential for stable income with an absolute return focus. To learn more about how Schroders can fit into your portfolio, please visit their website or the fund profile below.

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